2.3 Big Ideas Questions webnote 230 2.3 Big Ideas 1 BiG Questions for 2.3: • (repeat Q1 for employment, growth, inflation and distribution of income) • 1) Explain ONE of the key economic objectives of government + explain 2 policies that government could use to achieve the objective? • 2) Evaluate government efforts to improve ONE economic objective that governments want to achieve? 3) (only for distribution of income) Why is distribution of income important for a macro economy and for development ?
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2.3 Big Ideas Questions · 2.3 Big Ideas Questions webnote 230 2.3 Big Ideas 1 BiG Questions for 2.3: • (repeat Q1 for employment, growth, inflation and distribution of income)
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2.3BigIdeasQuestions
webnote 230 2.3 Big Ideas 1
BiG Questions for 2.3: • (repeat Q1 for employment, growth, inflation and
distribution of income) • 1) Explain ONE of the key economic objectives of
government + explain 2 policies that government could use to achieve the objective?
• 2) Evaluate government efforts to improve ONE
economic objective that governments want to achieve?
3) (only for distribution of income) Why is distribution of income important for a macro economy and for development ?
2.3BigIdeas
• Unemployment• Inflation• Growth• Distribution
webnote 230 2.3 Big Ideas 2
Read the syllabus items to understand the IB focus for this economic theory !
Disquilibrium unemployment as labour market is not in equilibrium as wages do not fall to w1 due to trade unions.
BigIdea
2Know equilibrium versus disequilibrium unemployment (use AS/AD for Labour) and the concept of a cyclical downturn or cyclical unemployment
Economy is in equilibrium at yfe but even though there is natural un-employment the labour market is in equilibrium. Diagram is for final goods and services.
NB AS+AD for final goods and services behaves the same way as AS+AD for labour.
Demand for labour falls to w1 q2 due to a recession but wages stick at w3 due to trade union opposition.
This results in disequilibrium unemployment of q1-q2.
q1 q2
Cyclicalunemployment
webnote 230 2.3 Big Ideas 5
Business cycle is a useful diagram to show cyclical downtuns over time
There are 2 diagrams to use to show ‘gaps’: inflationary and recessionary (defationary). The ‘gaps’ are shown using the monetarist LRAS (Diag 1) but they can also be shown using the keynesian LRAS. See Blink p 195 or webnote 220 item
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3
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DiagramD:supplysideordemandsidemanagment
• SupplysideorDemandside PL
Real GDP 0
Yfe + Un
LRAS: supply side policies
Webnote 230
Demand side management
PL
Real GDP
webnote 230 2.3 Big Ideas 7
LRAS lras 1 lras 2
lras 3
lras 4 AD1 AD2 AD3
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4Know that there are 2 major alternatives to bring growth ( more jobs) to an economy but several policies can be used to achieve either demand side or supply side management of the economy. 2 alternatives are supply side or demand management.
DiagramA:Short/LongRunPhilipsCurve• PhilipsCurve
Inflation/Money wages
% unemployment 0
Webnote 230
webnote 230 2.3 Big Ideas 8
Un = natural unemployment
srpc lrpc
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5 The short and long run Philips curves show the relationship between inflation (money wages) and unemployment.
Keynesians believed in the ‘trade off’ ( ) between unemployment and inflation seen in the SRPC arguing that growth could be managed inversely with inflation but the monetarist view in the LRPC argued that the move from blue to red would only be in the short run and due to ‘money illusion’ unemployment would revert to yellow over time but at a higher price level – see green dot. In the case of the LRPC then there is no impact on output but with changes in the price level. The result of policies to reduce unemployment below Un will only be higher inflation. This then is the core of the monetarist / classical argument against demand side policies.
DiagramA:Short/LongRunPhilipsCurve• PhilipsCurve
Inflation/Money wages
% unemployment 0
Webnote 230
webnote 230 2.3 Big Ideas 9
Un = natural unemployment
srpc lrpc
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5 The short and long run Philips curves show the relationship between inflation (money wages) and unemployment. How does AS-AD react to injections?
AS-AD analysis
0
Price Level
Real GDP
AS 1 AS 2
AD 1
AD 2
How does AS-AD react to injections to reduce
Un Injections (shift in AD) cause a movement along the SRPC BUT this causes higher wages and economy readjusts at Un
lras
= inflationary gap
• PhilipsCurve+StagflationInflation/Money wages
% unemployment 0
Webnote 230
webnote 230 2.3 Big Ideas 10
Un = natural unemployment
srpc1 Stagflation was a real alternative and occurred in the UK in the 1970‘s where inflation and unemployment were rising simultaneously.
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5 The short and long run Philips curves can show the relationship between inflation (money wages) and unemployment.
srpc2
DiagramD:supplysideordemandsidemanagment
• SupplysideorDemandside PL
Real GDP 0
Yfe + Un
LRAS: supply side policies
Webnote 230
Demand side management
PL
Real GDP
webnote 230 2.3 Big Ideas 11
LRAS lras 1 lras 2
lras 3
lras 4 AD1 AD2 AD3
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4Know that there are 2 major alternatives to bring growth ( more jobs) to an economy but several policies can be used to achieve either demand side or supply side management of the economy. 2 alternatives are supply side or demand management.
DiagramD:supplysideordemandsidemanagment
Demandside Inflation
unemployment 0
Yfe + Un
Webnote 230
Demand side management
PL
Real GDP
webnote 230 2.3 Big Ideas 12
LRAS Government injections from yellow to red to blue on figure 2 lead to sifnificant
AD1 AD2 AD3
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6What is the Keynesian solution to unelployment?
DiagramD:supplysideordemandsidemanagment
• SupplysideorDemandside PL
Real GDP 0
Yfe + Un
LRAS: supply side policies
Webnote 230
Demand side management
PL
Real GDP
webnote 230 2.3 Big Ideas 13
LRAS lras 1 lras 2
lras 3
lras 4 AD1 AD2 AD3
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7What is the classical/monetarist solution to unelployment?
1. Uncertainty–investment2. Redistributioneffects–poormoreaffectedThereforePoverty1. Lesssaving2. Exportswebnote 230 2.3 Big Ideas 21
Know your vocabulary here: E.g. • Disinflation • Deflation • CPI • Producer Price index • Weighted price index
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2
InflationWhatdamagedoesinflationcause?
webnote 230 2.3 Big Ideas 22
A – below are 3 key problems caused by unexpected/unanticipated inflation: Some negative effects of inflation
1. Price Mechanism distorted: price mechanism serves to allocate scarce resources. This process is disturbed by inflation. The price mechanism has a major role to play in resource allocation. If the mechanism does not work due to problem inflation then the economy will function less effectively. Price mechanism allocates resources (FOP) and if the signalling system is damaged by unexpected inflation then poor allocative decisions will result.
2. Uncertainty: business and consumer confidence is affected. This impacts upon I and C in terms of
the AD model. Important to note here is that investment may fall because firms don’t know the cost of undertaking investments/expansion of the business firm. Look out for ‘consumer’ and ‘business’ confidence indices in the syllabus!
3. Redistribution/ increased poverty: for low income earners where income does not follow the
inflation rate for extended periods of time e.g. for fixed income earners such as pensioners any increase may have to wait until the next fiscal budget.
This economy is performing poorly because the shift in the SRPC illustrates that both prices and unemployment are simultaneously increasing. This is definitely a case of ‘crisis economics’.
Assume that the economy is currently operating at e1: 1. Spiraling inflation occurs from e1 to e2 to e3 to
e4 to e5 2. The analysis commences at e1 which is the
base year for the CPI (index =100). 3. At e5 due to a fall in input prices the SRAS now
shifts from SRAS 3 to SRAS 2 and disinflation occurs as shown by the CPI as it falls from 115 to 108 but it is NOT deflation as this would require the cost of the basket to fall below 100 i.e. e7 where the index is 97.. This is understood to be disinflation because the cost of the basket of goods used to measure the inflation rate has fallen to PL 6 but this PL is not lower than the price level when the economy was in equilibrium at e1 which is the base year for measuring the inflation
4. E7 should NOT be understood as ‘good deflation’ when long run prices fall to CPI value 99. but this is unlikely to impact the economy in the short run. ‘Good deflation’ is not a realistic outcome as inflation is usually measured over a 5 year moving average and statistics do not support a long run deflation concept. In any case deflation is associated with a contracting economy e.g. sustained fall in price level accompanied by falling output e.g. e5-e4-e8.
SRAS 3
e1
LRAS 1
e2
e3
PL 1
PL 6
PL 5
Yfe/NRU (natural rate of unemployment)
e4
e5
e6
e7
Base = 100
99
104
108
112
118
113
Disinflation is when the rate of increase of the price level falls i.e. a lower rate of inflation
Can you spot which direction/ coloured dots relates to 1-4 ? 1. Demand pull inflation( good inflation) 2. Cost push inflation (bad inflation) 3. Supply side growth firstly with
disinflation in the short run and eventually deflation in the long run as supply side policies adjust the LRAS but note that the economy is growing (‘ryanair effect’ markets are getting bigger at lower prices i.e. deflation). Can be described as ‘good deflation’
4. Deflation. Bad deflation where prices fall and output is falling. Research Japan and deflation.
Note: Philips Curve cuts the ‘X’ axis at the Natural unemployment rate i.e. Yfe or full employment. This is the idea of “full employment with unemployment”.
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DiagramB:Long+ShortRunPhilipsCurve
Fig1:PhilipsCurveSR+LR
Money wages / Inflation
% unemployment 0
Yfe + Un
Labour market in equilibrium with natural rate of unemployment and can be = full employment equilibrium or yfe = Un AD (L) AS (L)
LRPC:
No “ trade off “
Webnote 230
PL
Real GDP
webnote 230 2.3 Big Ideas 30
lrpc 1
Avg wage
Q of labour
HL Only - LRPC
“ trade
off “
lrpc 2
Fig 2: AS + AD to show demand side managment
0
Can natural rate be reduced using ‘Demand’ side policies? SRPC indicates YES. LRPC indicates NO. See Blink C18, p.240 and ‘money illusion’. Neo Classicals argue that if Un can be reduced then supply side policies must be used and not demand side which will see no output increase but a higher price level
AD 1 AD 2 AD 3
Classical economists argued that natural rate could be reduced by shifting lras 1 to lras 2 in Fig 2 and therefore lrpc 2 is possible i.e. a lower rate of natural unemployment.
Note that a higher tax revenue indicates a higher level of economic activity i.e. growth . T* shows that the best average tax rate will result in higher growth resulting in higher tax revenue Note: Laffer is not in the syllabus but well worth knowing
High level of economic activity at T*
lower level of economic activity and tax revenue with tax rates above T* i.e. disincentive
M11/3/ECONO/HP1/ENG/TZ2/XX/M 2. (a) Explain two policies a government might use to redistribute income. [10 marks] (b) “Measures to promote greater income equality should be a key feature of government economic policy.” Evaluate this proposition. [15 marks]